Trade and Domestic Policy in Models with Monopolistic Competition

Chiara Forlati's webpage

Abstract: We consider unilateral and strategic trade and domestic policies in single and multi-sector versions of models with CES preferences and monopolistic competition featuring homogeneous (Krugman, 1980) or heterogeneous firms (Melitz, 2003). We first solve the world-planner problem to identify the efficiency wedges between the planner and the market allocation. We then derive a common welfare decomposition in terms of macro variables that incorporates all general-equilibrium effects of trade and domestic policies and decomposes them into consumption and production-efficiency wedges and terms-of-trade effects. We show that the Nash equilibrium when both domestic and trade policies are available is characterized by first-best-level labor subsidies that achieve production efficiency, and inefficient import subsidies and export taxes that aim at improving domestic terms of trade. Since the terms-of-trade externality is the only beggar- thy-neighbor motive, it remains the only reason for signing a free-trade agreement in this general class of models.